Sometimes I agree with Dr. Jen

I rather suspect I favor a bigger and faster appreciation of the RMB over time than does Dr. Jen, but I very much agree with his argument for a bit more RMB appreciation in the near term. Stephen Jen of Morgan Stanley, in his most recent note:

I do believe that, relative to the trends in China’s external account, the pace of crawl of USD/CNY is too slow. First, the argument that China’s exporters are sensitive to a modestly stronger CNY is no longer compelling. Second, a stronger CNY has merits, from the capital account perspective. Third, the rapid growth in China’s official reserves is becoming a problem. Fourth, the real effective exchange rate of the CNY has not changed since 2003, despite the move in USD/CNY. The bottom line is that the cost-benefit proposition no longer justifies China confronting the US Congress over the USD/CNY parity.

(Update: the internet version of Jen's note is here. I should add that while I agree with much of what Jen wrote, I never have found the argument that China's financial sector wasn't ready for a bit more RMB appreciation compelling. China's financial sector never had a currency mismatch. What China needed to do was to clean up the banks bad domestic loans. And in lots of ways, the slow pace of RMB appreciation and the associated need for lending curbs has slowed banking reform. I also don't quite see how selling off small stakes in banks that are still majority owned by the state constitutes "privatization.")

I also agree with another point Dr. Jen makes in his most recent note: the enormous growth of state investment funds is leading to a shift in the balance of financial power, one where the "financial" power of the public sector is growing relative to the financial power of the private sector. And specifically one where the financial power of the public sector in emerging economies is growing relative to the private sector in advanced economies.

So far though, the enormous influx of funds from the public sector in emerging economies into US and European markets has been nothing but a boon to most players in the private market. They may not be as powerful as they once were (who is now afraid of the bond market?) but they are a lot richer than they used to be. And Wall Street and the City have always cared more about money than any thing else ...

"Liquidity" is a nebulous concept. Everyone thinks that there is a lot of it out there. Financial assets (including complex ones) are easy to sell, making it easy to raise money for new lending or new investment. But if you look at classic measures of money growth, the US doesn't seem to be creating quite as much of it as it once did -- at least according to the measures the Fed uses (M1 and M2, see the graphs here; M3 may tell a different story). Central banks have tightened short-term rates even if long rates haven't followed. Credit Suisse notes that the gap between policy rates and nominal GDP growth -- one of its measures of excess liquidity -- has shrunk.

As Jon Anderson of UBS points out, emerging market central banks cannot create dollars -- only their own currency. They have to buy (or borrow) their dollars on the open market. They aren't the ultimate source of dollar liquidity, at least as it is classically defined.

At the same time, I don't think anyone doubts that a lot of emerging market savings is now on deposit with banks in New York. And the amount on deposit in New York pales relative to the amount on deposit with banks in London. Those funds are available to be lent out to those in need (i.e. private equity funds -- the new kings of Davos). That is another meaning of liquidity: those who want to borrow seem able to find funds to borrow easily, and at a reasonable price.

And when the Saudis or the Chinese buy an Agency bond from a US pension or insurance fund, that fund is left with an influx of dollars -- dollars that ultimately stem from the recycled US trade deficit -- that they want to put to work.

That creates a lot of demand for a lot of other kinds of financial assets -- whether the domestic dollar denominated bonds of a government still formally in default on some of its external bonds or complex structured products with lots of embedded leverage ...

Emerging market central banks may not be able to create dollars, but they are behind a lot of the world's demand for various kinds of dollar-denominated financial assets ...